Special：Xing Talk—Celebrities Interview



About Prof. Stephen Brown
Stephen J. Brown is David S. Loeb Professor of Finance at the Leonard N. Stern School of Business, New York University. He graduated from Monash University in Australia and studied at the University of Chicago, earning an MBA in 1974 and a Ph.D in 1976. Following successive appointments as a Member of Technical Staff at Bell Laboratories where he spent time on assignment as District Manager in the AT&T Pension Fund, and Associate Professor at Yale University, he joined the faculty of New York University in 1986. In December 2002 he was appointed to the honorary position of Professorial Fellow with the title of professor at Melbourne Business School of the University of Melbourne. He has served as President of the Western Finance Association and Secretary/Treasurer of that organization, has served on the Board of Directors of the American Finance Association, and was a founding editor of the Review of Financial Studies. He is a Managing Editor of The Journal of Financial and Quantitative Analysis and has served on the editorial board of The Journal of Finance and is on the board of the Pacific-Basin Finance Journal. and other journals. He has published numerous articles and four books on finance and economics related areas.

Questions

Xing Zong: Prof. Brown, thanks so much for taking my interview! Let’s focus on hedge fund in this interview. In my opinion, there are 3 distinguishing characteristics of hedge funds: first, it can hedge; second, it uses derivatives; and third, it has the ability to use leverage. The first question for you, what is meant by “hedge”? Could you please explain to our readers in layman’s terms?

Brown: The term ‘hedge fund’ was invented by a journalist by the name of Carol Loomis who in a Fortune magazine article written in 1966 used this term to describe the investment philosophy of AW Jones. AW Jones was a pioneer who set up the first such fund in 1949. He invested in undervalued companies financed in part by short positions in companies he felt were overvalued. These short positions mean that he borrowed the stock, sold it hoping that the stock would fall in value before he had to buy it back again to return it to the original owner of the stock. In this sense, Loomis argued, he was “hedged” against general market movements, because if the stock market rises, the first part of the strategy, the “long” component, pays off. If the market falls, the second part of the strategy, the “short” component, pays off. Unfortunately, this journalist’s explanation was not entirely accurate, because the short positions were small in size and did not match the economic significance of the long positions. For this reason, the fund could not provide much of a “hedge” against market movements.

To implement this strategy, AW Jones had to obtain exemption from Federal Government regulations that prevent public funds from engaging in these kinds of short positions. If the investors are wealthy enough to understand and bear the risk involved, under U.S. rules they are permitted to invest their money in unregistered investment partnerships so long as the size of the partnership is limited (initially to 99 investors) and the partnership does not advertize or otherwise generally solicit business. These unregistered investment partnerships can engage in all kinds of investments, including short positions, derivative securities and leverage, and there are no limitations on the kind and scale of fees that may be charged. This freedom from government regulation and oversight was attractive to many other funds, who called themselves “hedge funds” although they did not use AW Jones’ long-short strategy. The term “hedge fund” now refers to any kind of unregistered investment partnership. These funds use many different kinds of investment strategies. The most common investment strategy remains AW Jones’ long short strategy, but it is in the minority (only 39% of funds adopt this strategy, accounting for 35% of assets under management as of December 2006).

Xing Zong: Derivatives play such an important role in the financial market because these are cutting edge innovative financial instruments. What is your general thought on that and can mutual fund also use these strategies?

Brown: Actually, while derivatives play a large role in contemporary financial markets, they are not at all “innovative”. The first derivatives we have reliable records of date from the Zhou period in China, beginning around 1000BC. The idea that pieces of paper could be exchanged without reference to their intrinsic value but rather the value of what they represented was a major advance in human civilization. There are many kinds of financial strategies using derivatives. By exchanging pieces of paper, farmers have over thousands of years been able to shift the risk associated with growing food to city dwellers. In the very recent past we have learned that hedge funds have been providing a conduit through which paper passes from banks in impoverished neighborhoods to wealthy individuals best able to bear the risk of providing and financing housing in these poor neighborhoods. The risk associated with many kinds of derivatives transactions can be very great, and for this reason there are limitations on the extent to which mutual funds may engage in transactions of this nature. The rules sound very complicated, but they amount to the commonsense rule that public funds may not use derivative positions to create a situation where they are effectively selling securities they do not own. Otherwise, it is perfectly acceptable for public funds to invest in derivative securities so long as these activities are reported and other rules are followed.

Xing Zong: For “leverage” here, where does hedge fund go for the leveraged money? What are they used for collateral? People say if interest rates go up, it is detrimental to hedge fund, why?

Brown: When hedge funds are confident they have found a positive value strategy, then it might be appropriate to borrow money to invest in this strategy. There is considerable risk here, because just as the returns can be multiplied by borrowing to invest in the strategy, the losses can also be multiplied if the strategy turns out to be wrong. For this reason, leverage is used mostly in fixed income arbitrage hedge fund strategies where the risk is relatively low. This corresponds to about 4% of the assets managed by hedge funds as of the end of 2006. There are two types of leverage. The first is direct leverage: loans issued by banks and prime brokers to hedge funds to allow them to invest in securities. The second type is referred to as “embedded leverage”, or the leverage implied by derivative transactions or short sales where securities are borrowed and sold to purchase other securities. In either case collateral is required, and this collateral is often a mix of cash and securities.

The detrimental effects of sharp changes in interest rates are not caused by leverage, although leverage can magnify the negative effects of interest rate changes. Most hedge funds earn high returns by the willingness of their wealthy investors to provide liquidity to the markets, by being willing to buy when no one else is willing to buy and to sell when no one else is willing to sell. These investors earn a considerable return for doing so. However, in a liquidity crisis, even the deep pockets of the richest investors may not be sufficient. This is essentially what happened to Long Term Capital Management when it failed in 1998. Liquidity crises are very dangerous times for most hedge funds, and such times are often characterized by sharply rising interest rates.